A Disruptive Proposal by the IMF

Hoping to learn from what it sees as its missteps in handling the Greek bailout and other recent crises, the International Monetary Fund (IMF) is quietly wading into one of the most sensitive issues in international finance: how to balance political, economic, and financial considerations when a country might not be able to pay back its debts.

Specifically, some at the IMF are suggesting that, as a precondition for financial assistance, countries would be required to force private creditors to accept losses when the borrowing country's debt sustainability is uncertain and market access has been lost. The Fund will act as the lender of last resort only if the private sector shares the pain.

However well-intentioned, such a policy shift would probably disrupt markets, increase episodes of default, raise borrowing costs, and discourage countries from seeking the IMF's help when they most need it.

The IMF argues that countries sometimes wait too long to seek its assistance, increasing the amount of money required for a bailout and allowing some private investors to cash out their holdings at public expense. The IMF's first Greek rescue program, for example, allowed investors, including German and French banks, to be paid in full, thus avoiding responsibility for their poor lending decisions. The IMF justified this decision by citing the risk of a systemic meltdown.

To better protect its resources in the next crisis, the IMF is considering abandoning this systemic exception and establishing more rigid rules for the model it uses to assess a country's ability to repay its debt. Under the system being considered, the IMF would establish thresholds for debt sustainability, and if a country breaches those limits, it would be judged on its perceived sustainability and ability to access markets. If both sustainability and market access are found wanting, there would be a presumption of limited costs imposed on creditors, forcing the country to temporarily delay repayments to its bondholders in exchange for IMF support.

The problem with this model is that predetermined thresholds will inevitably conflict with the unpredictable circumstances of reality. The IMF's analyses must always involve a degree of judgment and subjectivity. It is hard to imagine a model that captures the particularities of Argentina and Greece but excludes those of Italy or Japan.

Regardless of its form, the imposition of costs on investors—known as private-sector involvement—requires them to accept less than they are entitled to. Forcing bondholders to take a loss may occasionally be necessary to exert discipline but should never be easy or common. After all, restructuring is simply a more diplomatic term for a fundamental breach of contract between a country and its lenders. Were such imposed losses to become more common, funding costs would almost certainly rise for all but the safest of nations.

The IMF's role should be to rescue countries in times of crisis and bolster market confidence and stability. Therefore, its financial support should never be disruptive. Yet, in part because of its preferred creditor status, the IMF's most recent intervention in the euro area resulted in higher borrowing costs for the very nations it intended to help. The IMF's suggested plan would have a similarly destabilizing effect, and countries would almost certainly be less likely to seek early IMF involvement in the future, the opposite of the policy's goal.

Making private-sector involvement the norm would also reduce the global supply of risk-free assets, with more countries' bonds potentially subject to losses in times of financial crises. Injecting credit risk into otherwise risk-free sovereign debt could cause a migration of the investor base, introducing return-hungry credit-investors who base their decisions on default probabilities rather than economic fundamentals such as growth.

There is a better way to meet the IMF's goal of limiting its risk while staving off contagion. For example, a more rational pricing of risk could be achieved by earlier and more thorough IMF surveillance, including better scrutiny of cross-border flows, corporate currency mismatches, and debt holdings. Regular assessments of debt sustainability could be included in the IMF's World Economic Outlook and the Global Financial Stability Report. Louder naming and shaming to force early policy corrections is a far better approach than promoting a presumption of risk for the private sector.

Furthermore, IMF rescues should always seek to achieve success at the least possible cost to growth. If the appropriate crisis response involves a full bailout, then that rescue should be provided (with appropriate conditionality). If losses to bondholders are appropriate, then they should be part of a solution that reflects a country's needs and systemic circumstances. Appropriate prescriptions will always depend, in part, on the political will of a country to implement them.

Private-sector involvement should never be ruled out. However, there is no reason to abandon the IMF's current case-by-case policy or to presume that breaches of contract are necessary. Predetermined formulas are doomed to be misapplied with unanticipated consequences. By using these instruments, instead of fostering financial stability, the IMF could introduce greater risk, uncertainty, and costs to the global financial system. Surely, that isn't the Fund's goal.